Credit Traps

Abstract

This paper studies the limitations of monetary policy in stimulating credit and investment. We show that, under certain circumstances, unconventional monetary policies fail in that liquidity injections into the banking sector are hoarded and not lent out. We use the term "credit traps" to describe such situations and show how they can arise due to the interplay between financing frictions, liquidity, and collateral values. We show that small contractions in monetary policy can lead to a collapse in lending. Our analysis demonstrates how quantitative easing may be useful in increasing collateral prices, bank lending, and aggregate investment.